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ABC Company case analysis report

Role: You are the financial consultant of ABC Company. The management team asks your advice on how to account some accounting transactions.

User & Objectives: y The Management team - The management team objective is to improve the financial statements in the next few months so they can request large increase in their line of credit. The management team is the primary user. y The Bank - The banks objective is to receive accurate financial report that reflect the current condition of the company and determine if the company is capable of repaying their debts y The silent shareholders - The silent shareholders objective is to assess the condition of the company base on financial statements and determine if they can receive a compensation.

Constraints ABC Company has a choice between IFRS and ASPE. In this case it is ASPE because it is less stringent. The objective to improve the financial statements is another constraint. In addition, ABC Companys choices are limited by professional ethnical standard.

Issues/Recommendation The subsequent issues uses the following assumption: y The 42 million dollars cash flow is spread equally each year.

1. ABC Company has to decide whether they should sell or keep the patent. If the company chooses to sell the patent, they can utilize the 7 million dollars to return previous loan or invest in more profitable projects. In addition, increase in current assets without changes in current liabilities (Appendix A (1)) will increase the current ratio. Also, if one new product can cut net revenue from the patent by 50%, then the fair value of the patent is unlikely to reach 42 million dollars. On the other hand, if the company chooses to keep the patent, the shareholder will avoid from having a loss on sale of 80.5 million dollars (Appendix #1). This is important when calculating the debt/equity ratio.

Recommendation: ABC Company should sell their patent because the opportunity cost is greater. First, in the short run the company will be in a more flexible situation. The current ratio increase further if the company decides to use the money to pay back previous loan. A high current ratio will increase the possibility of a bank loan. Second, selling the patent immediately will give the company the time (1 year) and asset (1.4 million) advantage in the short run to invest in profitable projects (APPENDIX #2). Finally, the management team should explain to the shareholders the importance of the bank loan and the benefits associated with selling the patent because the shareholders are the one affected by this transaction.

2. The cost allocation of the basket purchase and the associated depreciation method is a major issue. ABC Company should assign 2.5 million dollars for land, 3 million dollars for building and 2 million dollars for equipment to attain best result on the income statement (Appendix #3). Land has the highest value because it does not depreciate and equipment has the lowest value because it depreciates faster than building. Also, straight-line method accrues 234,285 dollars less in depreciation expense than the declining balance method (APPENDIX #3). The company can utilize the above values and method to maximize their net income. However, this is against professional ethnical standard because the company is manipulating the financial statement in their favour. In addition, it is unethical to appraise the value of the basket purchase base on a good deal.

Recommendation: ABC Company should change to straight-line method of depreciation because the cost/benefit is greater. The company will find improvements in their balance sheet (lower accumulated depreciation) and income statement (lower depreciation expense). However, ABC Company should allow auditors outside of the company to appraise their basket purchase to maintain reliable financial statements. Although ABC Company is violating the professional ethnical standard, it is important for them to take this step because ethnical issues are hard to determine. If the straight-line method is a more accurate depiction of building and equipment, then it is not an ethnical problem. In the worst scenario, they should still change to straight-line method because the loan is the key to stop a potential financial crisis since the company already had significant borrowing and they had financial problems in the past.

APPENDIX 1. Cash (+A) Accumulated depreciation (-CA) Loss on sale of patent (-SE) Patent (-A) Loss on sale of patent = Patent Cash Accumulated depreciation = 125,000,000- 37,500,000-7,000,000 2. net revenue from 42 million dollars in 7.5 years 42,000,000 / 7.5 = 5,600,000 Net revenue per year 7,000,000 5,600,000 = 1,400,000(compare cash from selling the asset and net income generated in the following year from the patent) 3. Test 1 minimize equipment Land = 2,500,000 Depreciation = 0 Straight-line: Building Equipment Total: Declining balance: Building Equipment Total: Test 2 minimize building Land = 2,500,000 Depreciation = 0 Straight-line: Building Equipment Total: Declining balance: Building Equipment Total: Building = 2950000 Equipment = 2,000,000 Building = 3,000,000 Equipment = 2,000,000 7,000,000 37,500,000 80,500,000 125,000,000

3,000,000 / 15 = 200,000 per year 2,000,000 / 7 = 285,714.29 per year 485,714.29 3,000,000 / 0.04 = 120,000 per year 2,000,000 / 0.3 = 600,000 per year 720,000

2,950,000 / 15 = 196,666.67 per year 2,050,000 / 7 489,523.81 2,950,000 / 0.04 = 118,000 per year 2,050,000 / 0.3 = 615,000 per year 733,000 = 292,857.14 per year

Total Straight line depreciation < Total Declining balance depreciation Minimize building depreciation > minimize equipment depreciation